Is Now a Time for Roth IRA Conversions?

Hey, what's up everyone and welcome to the School of Personal Finance. So the market, the sell-off continues. It has been nothing but pain for pretty much the last two months. What I want to talk about in this video is the opportunity to do Roth IRA conversions. So in this video I'm going to talk about what a Roth IRA conversion is, why right now it might be a great time to go ahead and pull the trigger on a Roth conversion, how to determine for yourself if it makes sense, because it is totally specific on your individual situation and your current income and tax brackets. And also if you do decide that it's right for you, how you go ahead and you pull the trigger to make it happen. All right, let's get to it. All right, so real quick, come follow me on LinkedIn, send me an instant message. I love meeting more and more of you over there on that platform. And the second thing is head over to schoolofpersonalfinance.com and get on my email list. Download the free PDF, 15 numbers to track to become great with your money. All right, so let's do a quick refresher on why I love Roth IRAs and the difference between a traditional IRA versus a Roth IRA. And this even applies to 401ks because most 401k plans now have a Roth 401k option as well along with the traditional 401k. So with a traditional IRA or a traditional 401k, when you put money into it, you get a tax deduction in the current year. So you get to write that off of your taxes and it saves you some money in the current year. On the flip side, when you do a Roth IRA or you make Roth 401k contributions, you do not get the tax deduction now. You pay the taxes on the money and it goes in after you've paid your taxes. But then that money grows tax-free forever and it comes out in retirement, you pay zero taxes on it. So that is very nice. Whereas with a traditional, you have to pay ordinary income taxes when you take that money out in retirement. So many people who have saved in traditional IRAs and 401ks for many years, as they start to take distributions in retirement, that gets tacked on to their ordinary income. So I find with a lot of retirees, they are hesitant to really pull money out because they don't want to pay the taxes. It's almost like they're afraid to spend the money that they've accumulated all these years because they don't want the tax bill. And then you have a required minimum distribution starting at age 72, where the IRS says, listen, you can't defer the taxes forever on all of this money. You have to start taking money out because we want our tax revenue. So with traditional IRAs and 401ks, you have these RMDs. They force you to take money out, start spending that money because we want our tax revenue. So that is the big difference between traditional and Roth. And the main driver, the main determining factor when deciding which one is right for you is your current tax bracket. That's really it. If you are in a high tax bracket now, then it makes sense to do a traditional 401k or a traditional IRA and get that tax deduction now because it's worth more. If you're in a lower tax bracket now, then it makes more sense to pay the taxes now and put the money into a Roth account. This way you pay the taxes now in the low tax bracket, and then it grows tax-free forever. And then when you take it out in retirement, that money is completely tax-free. So your current situation, that is the driver on which one is right for you to choose. So then what is a Roth conversion? And all it is, is when you take money from a traditional IRA or 401k and you convert it into your Roth IRA or your Roth 401k. And by doing this, you're taking money that you haven't paid any taxes on in the traditional you are then converting it into a Roth where you are never going to pay taxes again. So because of that, it becomes a taxable event in the year that you make the conversion. So let's say very simple example, you have $100,000 in your traditional IRA and you want to convert $10,000 of it into your Roth IRA. You take $10,000, you convert it over, you will now owe ordinary income taxes on that $10,000 conversion. So you get a 1099 form, you'll have to declare it as ordinary income. So depending on whatever tax bracket you're in, you will owe income taxes on that $10,000. But now that money is going to be in your Roth IRA, you can invest it however you want to in there, and then it will grow tax-free forever. So that's basically all a Roth conversion is, taking the traditional money, converting it into the Roth money, biting the bullet, paying the taxes now, and then having the money grow tax-free forever. So why is right now a good time to be considering doing Roth conversions? And the answer is pretty simple. It's better to convert when the market is down. So let's look at a simple example again. So $100,000 in the traditional IRA, let's say in January you decided to convert the whole amount. So you converted 100 grand, you're going to have to pay ordinary income taxes on the $100,000 in this current tax year. And now fast forward until today, and let's say that the account value is down 30%. So that $100,000 conversion, it's only worth $70,000 now. It sucks that you had to pay taxes on the whole $100,000, and now here we are and it's only worth $70,000. Where if we look at the flip side of that, if you convert today, so say your account value is 100 grand in January, now it's worth $70,000, you convert today, you're only going to be paying taxes on $70,000 on the amount of the account today. And then hopefully the markets are going to go back up eventually, but let's say it eventually gets back up to $100,000, all that growth, that $30,000, it just basically gets you back to where we were in January, that would all be tax-free growth as well. So when the markets go down, it makes sense to think about doing conversions. It's not the only factor. We'll go into figuring if it's right for you, but that's the reason why it becomes more attractive in times like this, because the account values are down, it's a better time to convert and pay the taxes on it when the account value is lower. All right, so now let's talk about how you can determine if this makes sense for you and your situation. So the first thing that I always look at is, do you have enough money in the bank? Do you have enough cash in the bank to pay the tax bill that you're going to incur by doing the conversion? So the last thing you want to do is to use money from your IRA to pay the taxes on the conversion, because then that counts as a distribution, where you're going to have to pay taxes and a 10% penalty if you're younger than the age of 59 1⁄2 to use that money to go ahead and pay the taxes. So you have to use outside money, you have to use money that you have saved in order to pay the tax bill. So just to use very simple numbers again, if you convert $10,000 in the current tax year and you're in the 22% federal tax bracket, then you could assume that that's going to be $2,200 in federal taxes that you're going to owe by doing the conversion. So you have to make sure that you have that money saved in order to pay the tax bill when it comes due. If you don't have any money in the bank, if you don't have emergency savings, or if you're not sitting on some cash right now, then it just doesn't make sense to even think about doing Roth conversions. And then the second thing that you have to give some serious thought to is, do you think you're going to be in a lower tax bracket in retirement? Because if you are, then it doesn't make sense to pay the taxes now when you'll be in a higher tax bracket than when in retirement you will be in a lower tax bracket. Now obviously, nobody knows what the tax brackets are going to look like in the future. And my bet is on they're going to be higher than where they are today. The government, they're going to have to raise revenues, they're going to increase taxes over our lifetimes. I just don't see any other way. Yes, I could be wrong, but I do believe that the tax brackets themselves are going to be higher in the future than where they're at today. Now if you have very little income in retirement, which hopefully that won't be the case, but if you have very little income, then you might be in the lower tax bracket no matter what the tax brackets are at. So you have to give a little bit of thought to where you think your income will be in retirement and what your tax brackets might actually look like in retirement when determining if it makes sense for you to pay the taxes now in your current tax bracket or to pay it in retirement when you could be in a lower tax bracket. All this talk about tax brackets, let's just look at a quick example. Let's make the assumption that between you and your spouse, your income is $100,000. Let's say that you have W-2 jobs and you guys make $100,000 and then you're able to take your standard deduction. So after your standard deduction, your taxable income, that is what these numbers are based off of. It's actually, it's the bottom line, I believe line 15 on the first page of your tax return. So let's say that your taxable income is $75,000. So according to these tax brackets right here, that would put you in a 12% tax bracket, okay? All the way up to $83,550 is the 12% tax bracket. So if your taxable income is currently $75,000 and you assume it's going to be the same for the next year, then what you could do is you could convert up to this top of this 12% tax bracket, right? So you would know right off the bat, if your taxable income is $75,000, then you have $8,550 that you could convert and still be in the 12% tax bracket. That would make a lot of sense to me, right? We could even make the argument that you could convert more and that it still might be worth going up into this 22% tax bracket to convert a portion of your money. You just want to be able to do the calculation and see how much tax would I actually owe. So being in the 22% tax bracket now, you'd have to say, you know what? Do I think that I'm going to be in a lower tax bracket in retirement? So this is how you would want to kind of break it down and make a decision if it's worth doing conversions for you based on your tax brackets. If your taxable income is over $340,000 a year and you're in the 32% tax bracket, then probably not worth doing Roth conversions and paying 32% right now. The deductions are more valuable to you at this 32% tax bracket. There's a good chance that you will be in a lower tax bracket in retirement. And I always like to say that you never want to waste a low tax bracket. So you could be in a situation where maybe you got laid off this year, or maybe you're just having an off year with your business or whatever the case may be, and your income is very low and you're just living off of savings. If you have no to little income, then it might make a ton of sense to do Roth conversions. You might actually have zero taxable income where you could do conversions and not even owe any taxes on it, especially if you have a bunch of children and you're getting child tax credits on top of it, you could do conversions and pay zero tax on it. So you want to be aware of these things. But even if you're in the 10 or 12% tax bracket, I do think that those present great opportunities for Roth conversions. Again, as long as you have the money in the bank to pay whatever the tax bill is going to be at tax time, it could make a lot of sense for you. All right. And then the last thing I wanted to touch on is how you actually go ahead and pull the trigger if you determine that it is the right thing for you to do. So depending if we're talking about IRAs or 401ks, if it's 401ks, the first thing you need to do is you need to call your plan administrator, your HR department, and find out if they allow you to do in-plan conversions while you're working there. So hopefully that they do, and you can just do a conversion from your traditional 401k over into your Roth 401k right there in plan. That would be wonderful. Now, with IRAs, it's a little bit different. You have to go to whoever your broker's at. So you might have to open up a Roth IRA if you don't already have one. And I like calling them like with Vanguard, with Fidelity. You can do it online, but I would rather call and actually speak with somebody and make sure that everything is getting done correctly and that they go ahead and process the conversion for you. And then once it's complete, you will get a 1099R tax form showing that you had the conversion, that you did a distribution from your traditional IRA. It will have an exception code on there showing that it was a conversion. And then these brokers, they also send out a form 5498 after you file your tax returns, after the fact that just shows that you did move money into your Roth IRA as well. So you just want to keep good records of this. And you also want to make sure that you definitely want to pull the trigger. It used to be that you could undo Roth conversions if you found out when you filed your taxes that it really didn't make sense, that it wasn't a good thing to do, that you ended up being in the higher tax bracket than you initially thought. You were able to basically undo it. But that changed back when we passed the Tax Cut and Jobs Act in the end of 2017. So once you do it, there's no going back on this. You want to make sure. This is another reason why it's good to have an accountant that you trust that can run these numbers for you, because you're going to have to do it before the tax year is over. So you might not have the full picture of what it looks like for the tax year. So you want to make sure that you want to pull the trigger when you do go ahead and do it, because there's no going back on it. All right, everyone. That is it for this one. I hope that you found it helpful. Please make sure to hit that like button if you enjoyed this one. Subscribe to the channel if you are not subscribed already, and I will see you again in the next video. Thanks.